Markets were down in Japan and China in the second quarter of 2016. While it appears Japan will continue to show weakness in the short term, there were several bright spots in China that give us cause for optimism.
Yen strengthens post-Brexit
We continue to be significantly underweight Japan. During the quarter, the Nikkei 225 Index was down more than 7% when measured by the yen. However, if we consider a U.S.-dollar return, the Nikkei was actually up just over 1%.1
So why did the yen rise more than 8% in the quarter?
We do not believe that it’s the result of any action by the Bank of Japan (BoJ), whose unprecedented easing policy is approaching its limits. The BoJ made no significant changes in monetary policy last quarter. In addition, we don’t believe deflationary expectations in Japan are contributing to the strengthening of the yen either.
Instead, we believe global events – such as the U.K.’s vote to leave the European Union, which triggered a weaker global economy – are the top reasons for the stronger yen. Perceived “safe havens,” such as Japan, which runs at a large current account surplus, typically receive new flows when global risks increase.
However, a strengthening currency is generally negative for Japan as its economy is largely export-driven. For this reason, we believe there will be very little change in Japan’s economic situation and ultimately, Japan will have difficulty reversing its long-term economic stagnation.
Outlook for Japan
We have high conviction in our long-term EQV (earnings, quality, valuation) approach, which is based on bottom-up stockpicking and individual company fundamentals. We believe this is the right approach for the long term.
Nevertheless, in the shorter term, we continue to forecast weakness in the country, as earnings-per-share (EPS) revisions were down close to 5% during the quarter, likely due to the strong currency.2
Quality investments are currently difficult to find in Japan, with the next-12-months return on equity (ROE) for Japan still below 10%, as compared to Invesco International Growth Class, which has an ROE of close to 19%.2
China’s balancing act
The Shanghai Shenzhen Composite Index was down 5.4% in the second quarter, while the MSCI China Index was down just under 2% and the Hang Seng Index was nearly flat at 0.4%.1
From a macroeconomic perspective, China has been a balancing act. For example, its second-quarter gross domestic product was better than expected at 6.7% year-over-year, which was good, in our view, considering investment has been slowing.1
Moreover, the property market in China continued to be strong while stable levels of consumption supported the economy. Retail sales improved, but primarily from e-commerce.
In late 2015, the Chinese government made reducing excess capacity a top priority. Today, we can see that the capacity cuts are indeed happening, given negative volume growth for many sectors with overcapacity, including coal, steel and aluminum. This trend is aligned with our view that China is shifting to more value-added growth as income growth continues to drive consumption.
In addition, revenue revisions were down 1.6% in China for the second quarter, and EPS revisions were down over 5%.2 On a price-to-book (P/B) level, the market P/B of the MSCI China Index is roughly at its average of the past five years (1.4 times versus the average of 1.5 times).1
Opportunities in China
There are several sectors where we see pockets of opportunity, particularly in consumer staples, where prices have come down 25% from a year ago, according to the MSCI China A Consumer Staples Index.1 Longer term, we are generally optimistic about China as it transitions from an export-driven economy to a more services- and consumer-driven economy.